This is the first month that I have recommended shorting the market. There is just too much bad news out there for me to go long. I think it clearly is time to get smaller with your portfolio. In my opinion, the best way to carry out this strategy is to buy calls on Proshares Ultra short S&P 500 (symbol SDS). I will explain the details of the trade below, but first let me explain the reasons why I favor it at the moment.
1) The debt ceiling bill may fail in one house or the other. This seems unlikely at the moment, but, if the bill fails, the market will crash.
2) The ISM numbers this morning were truly terrible. When they are coupled with the GDP figures issued last week and many of the other indicators, it is clear that the economy has encountered more than just a bump in the road (to use Obama's term). The full import of these numbers has not been factored into the market in my opinion. I expect there to be a further drop over the next few weeks.
3) The unemployment report for July is likely to be another awful number. Indeed, it would be good news in my opinion if the unemployment rate just stays the same as it was in June. Weekly new claims for unemployment went down last week, but not to a level that indicates much in the way of job creation. Stories of large layoffs have begun making their way into the press with regularity. In short, things do not look good in the short term.
4) Bad unemployment numbers would further reinforce the current unease of the consumer with resulting drops in consumer spending. This could form a cycle that feeds on itself with the result that the economy falls back into recession. Even if unemployment stays constant, it will take a while for consumer confidence to return and drive the economy.
5) If the ratings agencies downgrade the USA from AAA to AA, the will likely be a strong market reaction. coupling this with all the other items listed above, we may see a decline of a substantial nature.
So, in summary, there is a reasonably large chance that the market is heading south in a major way.
So what is the best way to protect against a market decline? most people cannot simply sell their stocks and exit from the market, nor would it make sense to do so. A much better solution is to have an investment that will rise if the market tanks so as to offset any decline. Proshareshares Ultra Short S&P 500 (symbol SDS) goes up by a double percentage each day of the amount that the S&P 500 declines. For example, if the S&P goes down 2%, SDS will rise by 4%. Further, one can buy calls on SDS in order to greatly increase the leverage available.
Here is an example: At the moment, SDS is selling for $21.82 per share. The September 24 calls could be purchased for 75 cents. If some form of bad news comes out that sends the market down by ten percent from here, SDS would rise about 20% to $26.18 per share. The value of the september 24 calls, however, would rise to at least $2.20 and depending on the timing probably to something more like $2.60. This is an increase of about 250% in the value of the calls. So, if the market tanks, these calls will soar.
Of course, there are some major caveats with regard to investing in SDS calls. First, these are highly risky; if the market goes up or even stays the same, these calls will wither away to nothing. It is imperative that you not use these calls as a primary investment vehicle; they are more appropriate to hedge one's portfolio against a disaster. Look at the amount you pay as an insurance premium which will protect a part of your ortfolio from decline. Of course, if the market goes way up, you will make plenty of money on your other holdings so that the loss on SDS will not be material.
Second, Because the market gyrates so wildly sometimes, it is imperative to be nimble in trading these options. Just look at today's trading. The market started out way up because of the debt deal. After the ISM numbers came out at 10:00, the market plunged. SDS calls went from being way down for the day at the open to being up about an hour later. Because SDS is a double of the S&P, it moves up and down much more quickly than most securities.
Third, just because you have a position in SDS calls, you cannot imagine that you have handled all the market risk. You need to carefully analyse your investments and get rid of those with excessive risk for the likely return.
Fourth, the most appropriate SDS calls change daily or even more often. As a result, if you have lack substantial experience trading options, you should stay away from these calls.
Finally, as I always say, you need to do your own due dilligence before investing. I make suggestions, but you need to make the decision based upon all the facts. Do your own research.
Disclosure: I am long SDS calls.
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